The 'Silicon Dragon' Reawakens

Rebecca Fannin has always been bullish on China's brainpower. In early 2008, she published Silicon Dragon: How China is Winning the Tech Race, a sort of manifesto and reference guide for China's slow but steady ascent toward becoming a worldwide leader in technological innovation. Fannin argued that the first wave of Chinese start-ups, which were created by returnees from abroad and essentially imitated foreign firms, were being replaced by a new crop of homegrown entrepreneurs with their own innovative technology and business models. (See Why China Will Win the Web)

Today, despite the 18 months of economic pain and vanishing venture capital that have followed her book's release, Fannin stands by its central thesis. The recession, she argues, hasn't altered the direction of China's rise so much as the country's speed. And in some ways, the global slowdown has only served to reduce Silicon Valley's head start in the race for innovation, leaving China poised to close the gap.

Forbes spoke with Fannin, a 17-year Asia veteran and editor of the Hong-Kong based Asian Venture Capital Journal, about her optimism in the face of stalled investment, frozen IPOs and increasingly tight Internet restrictions.

Eighteen months ago, you argued that China's technology industry was poised to shift from imitation to innovation. How has the global recession affected that transformation?

That trend is continuing. There's no doubt that venture capital investing worldwide has slowed down considerably, including Asia and China. But China is looking to rebound faster than any of the other markets.

I'm already starting to see a lot of new developments. For instance, Keystone Ventures, a new fund based in Beijing, recently closed a round of $200 million in spite of this very difficult time. We're also seeing a trend toward more RMB [renminbi] funds, domestic funds using Chinese currency. There's an evolving legal structure in China that's prevented some venture capitalists from investing, and these funds are helping local firms get more investment. Eight VC firms have raised RMB funds so far. And you see many Silicon Valley VCs actually moving to China now, instead of merely flying in and flying out.

Also, the Second Board, a Chinese board for listings of start-ups, is coming online, and there's quite a queue for companies to list on it, about 100 firms. There's a lot of hope that it could lead to renewed returns on investments in Chinese start-ups. There haven't been many IPOs in the last six months.

So China's market for innovative start-ups has been stalled to some degree?

If you look at the era when it was really bubbly in China, when the most money was raised and invested, the peak year was 2007, with about $10 billion invested. The next year was just under that, and the first half of 2009 has been far less. In China, as in Silicon Valley, venture capitalists are working closely with their portfolio companies to help turn them around, and that means they're spending less time focusing on new deals.

Nonetheless, I'm still seeing many companies getting financing. There's still a strong argument that China is moving up the ladder, from "Made in China" to "Invented in China." China, of all the markets in Asia, has the best chance of rebounding. It still has its entrepreneurial culture, its talent pool and a vast amount of money pouring into it. In fact, it currently receives about 41% of all of Asia's venture capital.

China's [$600 billion] economic stimulus plan will help too. And meanwhile, the economy is still growing at 8% or 9%. You still have the world's dominant Internet market, a massive mobile communications market, fast-paced economy, entrepreneurial talent and venture capital money.

Does that mean that even as the venture capital market as a whole slows down, the recession accelerated China's rise as a real competitor to Silicon Valley?

In some ways. The initial wave of start-ups in China was sparked by the returnees, foreign-educated Chinese tech workers who moved back to become entrepreneurs. Now you have these new local companies coming up and they're not as savvy or sophisticated as foreign returnees, but even in the recession they're getting financing from local firms. And that's driving a lot of new innovation.

In the first half of the year, 94 companies received investment in China, compared to 262 investments in Asia as a whole. So you can see that China is taking the lion's share, and emerging as an Asian powerhouse for start-ups.

Another measure of China's relative growth as an innovator is the number of patents it's filing. In the last year, it moved into sixth place worldwide, up from 10th place four years ago. That puts it right up there next to South Korea. [Chinese telecom equipment company] Huawei is the biggest patent applier of any company in the world.

What about the start-ups you pointed to as examples of innovation in your book, and in our last interview months ago. How have those companies, like mapping software company Pingco, the browser Maxthon or financial text messaging service Oriental Wisdom, developed in the midst of the recession?

In fact, none of the ones you mention have made the splash they hoped to. None have gone public or been acquired.

But other areas are showing more promise, like clean tech. The Chinese solar power company Suntech claims to have become the leading solar power company in the world in just the last six months. In the last couple months, Advantech Global Limited, a company that makes display technology that they claim is really revolutionary, announced a $14.1 million investment. AdChina, a Shanghai-based advertising networking, announced $18.5 million in investment, and eHi, a car rental company, announced $20 million.

But given that many of the companies you wrote about haven't created returns for investors, do you believe that China still merits so much investment?

I've seen research that shows that early-stage dollars on average go a lot farther in China than they do in the U.S. Although the analysis only looked at early-stage dollars, it showed that those series-A investments get 12 times the exit value for dollar invested compared to the U.S. And there are more exits, too, not just more dollars. This is all analysis I plan to include in my next book.

What is still the biggest hurdle for most Chinese start-ups?

Probably the biggest hurdle is management issues. With many start-ups, venture capitalists still have to bring in talent from overseas to fill certain positions, such as CFO. Often, a Western-trained CFO is still preferred for going through the IPO process.

In the West, we've been hearing a lot about a ramping up of censorship in China. In just the last few months, the central government threatened to install filtering software on every PC in the country, blocked Google for pornography, and continues to block access to sites like Facebook and Twitter. Has that heavy-handed approach stifled start-ups or made them more cautious?

This is an issue for Internet companies and not other China start-ups. And in some cases, it's far less of an issue if you're a Chinese company than it is if you're a foreign company. China has its own social networking sites like Mop.com and Kaixin.com. Even while Facebook is blocked, those sites haven't been blocked.

So in some cases, this kind of regulation really isn't hurting Chinese businesses. Instead it's given them even more of a home-field advantage.